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5 Main Drawbacks of ETFs
04/15/2014 6:00 am EST
ETFs have exploded in popularity, but Ed Devcic details five disadvantages that investors and traders must be aware of in order to make more informed choices and get the most out of these useful vehicles.
Exchange traded funds (ETFs) can be a great investment vehicle for small and large investors alike. These popular funds, which are similar to mutual funds but trade like stocks, have become a popular choice.
However, there are some disadvantages that investors need to be aware of before jumping into the world of ETFs. In this article, we will look at some of the disadvantages of ETFs.
Good information is an investor's most important tool. Read on to find out what you need to know to make an informed decision.
One of the biggest advantages of ETFs is that they trade like stocks. As a result, investors can buy and sell during market hours as well as put advance orders on the purchase, such as limits and stops.
Conversely, a typical mutual fund purchase is made after the market closes, once the net asset value of the fund is calculated.
Every time you buy or sell a stock, you pay a commission; this is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment's performance.
No-load mutual funds, on the other hand, are sold without a commission or sales charge, which makes them advantageous, in this regard, as compared to ETFs. It is important to be aware of trading fees when comparing an investment in ETFs to a similar investment in a mutual fund.
If you are deciding between similar ETFs and mutual funds, be aware of the different fee structures of each, including the trading fees. And remember, actively trading ETFs like stocks can severely reduce your investment performance because commissions can quickly pile up.
ETFs, like mutual funds, are often lauded for the diversification that they offer to investors. However, it is important to note that just because an ETF contains more than one underlying position, it doesn't mean that it can't be affected by volatility.
The potential for large swings will mainly depend on the scope of the fund. An ETF that tracks a broad market index such as the S&P 500 is likely to be less volatile than an ETF that tracks a specific industry or sector such as an oil services ETF. Therefore, it is vital to be aware of the fund's focus and what types of investments it includes.
In the case of international or global ETFs, the fundamentals of the country that the ETF is following are important, as is the creditworthiness of the currency in that country. Economic and social instability will also play a huge role in determining the success of any ETF that invests in a particular country or region. These factors must be kept in mind when making decisions regarding the viability of an ETF.
The rule here is to know what the ETF is tracking and understand the underlying risks associated with it.
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Liquidity and Price Spreads
The biggest factor for any new ETF is liquidity price spreads. Liquidity means that when you buy something, there is enough trading interest that you will be able to get out of it relatively quickly without moving the price.
New ETFs that have traded for just days or weeks may have larger spreads between the bid and ask prices (the price at which you can sell or buy). This can affect your profitability because the ETF has to increase in price more in order for your trade to make money.
New ETFs are launched every week these days because of the popularity of the security. Before you jump into that hot new ETF, be sure there is enough liquidity in the market so that you can get in and out of your trade quickly and with a reasonable spread between the bid and ask (no more than five or ten cents).
Capital Gains Distributions
In some cases, an ETF will distribute capital gains to shareholders. This is not always desirable for ETF holders, as shareholders are responsible to pay the capital gains tax. It is usually better that the fund retains the capital gains and invests them, rather than distributing them and creating a tax liability for the investor.
Investors will usually want to re-invest those capital gains distributions and, in order to do this, they will need to go back to their brokers to buy more shares, which creates new fees.
Lump Sum vs. Dollar Cost Averaging
This risk applies more to longer-term investors than traders, but it's still something every ETF buyer should understand.
Say $10,000 is what you want to invest in a particular ETF. You calculate how many shares you can buy and what the cost of the commission will be and you get a certain number of shares for your money.
However, there is also the tried-and-true small investor's way of building a position. This way is called dollar-cost averaging. With this method, you take the same $10,000 and invest it in monthly increments of, say, $1,000. This is called dollar cost averaging because some months you will buy fewer shares with that $1,000 because the price is higher. In other months, the share prices will be lower and you will be able to buy more shares.
Of course, the big problem with this strategy is that ETFs are traded like stocks; therefore, every time you want to purchase $1,000 worth of that particular ETF, you have to pay your broker a commission to do so. As a result, it can become more costly to build a position in an ETF with monthly investments. For this reason, trading an ETF favors the lump sum approach.
The rule here is to try to invest a lump sum at one time to cut down on brokerage fees.
The Bottom Line
Now that you know the risks that come with ETFs, you can make better investment decisions. ETFs have seen spectacular growth in popularity, and, in many cases, this popularity is well deserved. But, like all good things, ETFs also have their drawbacks.
Making sound investment decisions requires knowing all of the facts about a particular investment vehicle; ETFs are no different. Knowing the disadvantages will help steer you away from potential pitfalls, and, if all goes well, towards tidy profits.
By John Devcic, freelance writer, market historian, and private speculator
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